Risk vs Returns I Understanding the Role of Risk in Investments I Kristal.AI

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Risk and Return Trade-Off: Understanding Risk in Investments

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The very term itself implies negativity. One steers clear of risks in daily life and would want to do the same when it comes to investments. After all, the thought of losing your hard earned money can keep you up all night with terrifying nightmares.

However, is risk really that bad when it comes to the world of investments? Though you may think the answer is a resounding yes, it is actually more nuanced than that. This is because of a concept known as risk and return trade off. In this article, we will tell you all about the same.

What is the Risk and Return Trade-Off?

When a fund is associated with high risk, the expectation is that the returns will also be high. Similarly, when a fund is associated with low risk, investors can expect lower returns. The choice that an investor makes in with regards to the risk they want to take versus the returns they want to gain is known as the risk return trade off. It is what helps investors decide whether they are willing to take high risks with their investments, or whether they are happy with lower returns that come with safety. Each investor has their own risk appetite, which is why the risk-return trade-off varies with each person.

Making Your Peace With the Risk-Return Trade-Off

There are many factors that impact an investor’s risk return trade off. The first, of course, is the investor’s risk appetite (as mentioned earlier). If an investor does not fear risk and can whether the ups and downs of the market with a greater goal in mind, then that person has a high risk appetite. However, if an investor is more likely to panic every time the market dips, and prefers a sense of security over high returns, then that person has a low risk appetite.

Apart from this, investors must also consider their end goals when it comes to making specific investments. If an investor is looking for goal-based investments, then it makes sense to lower your risk exposure. When you have a milestone that you want to achieve in a set number of years, you can choose funds that offer an appropriate range of growth and invest accordingly. The question of taking risks is minimised here as one needs to achieve the specific goal. On the other hand, investors looking for wealth building can afford to take more risks as the goal is to grow one’s wealth as much as possible.

Investors must also consider how far they are from their retirement years. The further away that you are, the more likely it is that you can take risks without facing too many repercussions when it comes to retirement and your lifestyle after you stop earning. However, an investor in his/her 50s must be more cautious as the retirement years are just above the horizon and it is essential to be able to have financial independence at this time.

Finally, investors also have to consider their own finances while deciding their risk and return trade offs. If you believe that you can financially recover from a potential hit, then you can allow yourself to take certain risks while investing. However, let’s say you are a young investor who has just begun their career. At this stage, you may not be able to recover from a financial blow as your earnings are quite limited. Sticking to a low-risk fund can help you accumulate some wealth over time, without giving you an anxiety attack!

Singular Risk and Portfolio Risk: Must Your Risk Levels Stay Constant?

As an investor, or a potential one, you can invest in a single entity and then build your portfolio over time. Now, when investing in a single entity (like a mutual fund), you can choose your level of risk. However, your overall risk levels can be quite different when it comes to the entire portfolio. Let us explain with an example.

Ann Young is in her 20s and want’s to invest in a mutual fund for 7 years. She selects a fund that puts most of her money in the debt market and is satisfied with having lower returns. However, a few years down the line, she decides that she needs to diversify her portfolio and invests in penny stocks, which are high risk, high returns investments.

At this point, one can say that her portfolio is fairly balanced, as she has both, high and low risk investments. However, when she adds onto her portfolio with other investments, she can still choose to be a high risk taker, or a moderate one, and isn’t bound to the decisions of her past.

Investors can consider different levels of risk with every single investment that they make. In fact, this is generally advised as it allows investors to enjoy high ROIs and steady ones as well. Even if one investment fails, the security of the low-risk ones should keep the investor afloat through that. The goal is to always have some sort of a safety net that safeguards you from risk. As long as you can do that, you may find that taking risks becomes a much easier choice.

Of course, investors can enjoy a long and fruitful investment journey even without taking any risks throughout their lives. While it is not a necessity, it is also not the evil that many make it out to be! 

If you are wondering whether or not you should take high risks while investing, consider your goals, and the factors we have listed above before making the decision. Also, do understand the different types of investment options you have so that you can make more astute decisions regarding the growth of your funds and the risk that you want to take. Speaking to professionals should also help you understand which funds are the most apt for your needs. So, start defining the same before you pick your funds!